Analysis: Default or not, Asia a hostage to U.S. debt

Choonsik Yoo, Kevin Yao

7 Min Read

SEOUL/BEIJING (Reuters) - Unless the U.S. Congress settles a political showdown to raise the country’s debt ceiling in coming weeks, it will be left on the edge of an unprecedented default. But America’s main creditors in Asia may be the least of its worries.

Japanese 10,000 yen notes (L) featuring a portrait of Yukichi Fukuzawa, the founding father of modern Japan, $100 notes, featuring an image of Benjamin Franklin, and Chinese 100 yuan notes, featuring an image of former Chinese leader Mao Zedong, at the main office of the Korea Exchange Bank are seen in this picture illustration taken in Seoul October 22, 2010. REUTERS/Truth Leem

The creditors - China, Japan and other Asian governments - have a hoard of U.S. Treasuries in their $5 trillion cache of foreign exchange reserves, the equivalent of almost a third of U.S. gross domestic product.

Despite having so much at stake as bond prices lurch violently, they are not about to do anything more than minor tweaking of their portfolios.

Asian governments consider a U.S. debt default unthinkable and see the eventual tightening of U.S. monetary policy as a bigger issue for managing their reserves. Even if the United States was to default, its debt markets would still be the safest and most liquid in the world. Importantly, they take a far longer-term view than most private investors.

“We’re keeping an eye on potential market risks such as tapering, the debt ceiling and a government shutdown, but that does not necessarily mean we regard the current situation as critical,” a Japanese government official, who declined to be identified in the absence of authorization to speak openly to the media, told Reuters this week.

They also face a Hobson’s choice. These reserve managers would rather stay invested in Treasuries than be the cause of global market bedlam if they were to shift all that wealth.

More than 60 percent of the $5 trillion that Asian central banks hold is denominated in U.S. dollars and invested in American bonds and stocks, the International Monetary Fund estimates.

About $2 trillion of that amount was accumulated after November 2008, when the U.S. Federal Reserve embarked on its 5-year ultra-easy monetary policy, which included flooding global markets with cheap cash that drove U.S. yields to record lows.

Now, as an impending turn in Fed policy drives yields up and bond prices down, investors face a decline in the value of their bond portfolios.

A U.S. debt default would rock the bond market but most investors consider it implausible that U.S. lawmakers would allow that to happen. A similar political showdown in 2011 pushed the nation to within days of missing payments and led ratings firm Standard and Poor’s to strip Washington of its top-notch credit rating.

But veterans from both political parties in Washington are aghast that some lawmakers openly speak of managing a default that could be triggered next month if they don’t authorize more borrowing.

In exchange for agreeing to raise the $16.7 trillion debt ceiling, Republicans are seeking big spending cuts, which may strike at the heart of programs considered sacrosanct to President Barack Obama and his fellow Democrats.

Ironically, the uncertainty of Fed tapering and increasing the U.S. debt ceiling sent investors last week scurrying into the refuge of U.S. debt, rather than casting any doubt on how risk-free Treasuries really are.

Still, with the Federal Reserve set to relax its stimulus and eventually even tighten monetary policy, Asian reserves managers are preparing for a longer-term slide in the value of U.S. debt.

Making a profit from FX reserves had been easy during the last three decades as global interest rates gradually fell, said Choo Heung-sik, the head of Bank of Korea’s reserve management group.

“But the expected returns from bond investment will fall greatly in the future,” Choo said. “How to deal with this structural change in investment environment is what all the central banks are agonizing over.”

U.S. bond yields have already risen more than 100 basis points since May, when the Fed first indicated it is going to cut back on its $85 billion per month asset purchases.

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“We attach greater importance to safety and liquidity in managing foreign reserves,” the Japanese official said.

“From that standpoint, we undoubtedly see U.S. Treasuries as chief investment products with vast market size and high creditworthiness.”

Investors broadly are however more fixated on the Fed’s policy maneuvers than on the debt-ceiling debate. Many have scurried for cover by shifting to the short end of the market, which tends to see less volatility.

Central banks managing FX reserves in Asia have done likewise but on a much smaller scale, partly because they are mindful of the impact they could have on markets when they move their billions.

Data from the U.S. Treasury shows China’s holdings of Treasuries has declined modestly, to $1.277 trillion at the end of July from a peak of $1.297 trillion at the end of May.

But the composition has shifted. In the three months to March, Treasuries comprised 81 percent of China’s $66 billion purchases of long-term dollar bonds and stocks. That proportion dropped to 56 percent in the second quarter. In July, China sold $6.4 billion of Treasuries and bought $20 billion of bonds issued by U.S. government agencies.

The change in China’s allocation may reflect signs that the global economy is picking up, said an economist at the China Centre for International Economic Exchanges (CCIEE). China has the world’s biggest currency reserves at $3.5 trillion.

“China may be buying more risky assets,” said the economist, who declined to be identified. “When the recovery is shaky, China tends to hold more low-risk assets, such as U.S. Treasuries.”

Japan on the other hand was a net seller of dollar assets in the first half of the year, but a net buyer of $15.9 billion in July.

Asia in total has not been a net seller so far this year, but only 9 percent of the $23.5 billion invested in dollar assets in July went into Treasuries and a whopping 77 percent was channeled into higher-yielding agency debt.

South Korea, which has the world’s seventh-largest foreign currency reserves totaling more than $330 billion, hosted a closed-door conference in Seoul this week at which some 100 central bank officials from 36 mostly Asian and East European countries participated.

Choo said the central bankers were there to discuss the changing investment environment, in particular the question of dealing with a lasting rise in bond yields.

The risk of U.S. debt being downgraded again or a failure to pay creditors temporarily would not affect their thinking, he said.